UKWIR/Ofwat: efficiency methods (2006-2007)

The independent review of Ofwat's 2004 price control review process had suggested that a joint Ofwat/industry review of the controversial efficiency studies used by Ofwat should be undertaken.

UKWIR and Ofwat jointly tendered for this review through a project steering group. Reckon was awarded the project.

We conducted a thorough review of what Ofwat had done in 2004, and explored ways in which it might be improved or clarified in the future.

We examined in particular:

Comparative efficiency analysis. We considered the economic rationale for the analysis, econometric modelling approaches using cross-sectional data, sub-company data and time-series panel data, as well as alternative modelling approaches such as data envelopment analysis (DEA) and stochastic frontier analysis (SFA).

Analysis of industry-level trends in efficiency and expenditure. Our work included a detailed review of the methodologies applied in previous studies for Ofwat as well studies carried out for other regulators. We identified potential improvements to the analysis, and ways that the scope for future efficiency improvements in the water industry could be assessed drawing on newly available evidence on productivity trends and best practice from previous studies.

Alternatives to relative efficiency analysis. We examined the extent to which relative efficiency analysis could be replaced by, or complemented with, other forms of analysis. We considered the case for a single industry-wide efficiency assumption, the role of forecasts in company business plans and the potential use of menu regulation for efficiency analysis.

Reconciliation. We considered how evidence from different sources could be brought together and, in particular, what analysis could be done to reconcile the information from three main sources of evidence on unit operating expenditure requirements: relative efficiency analysis, industry-level efficiency analysis and company business plan forecasts.

Having reached some tentative views, we presented our work to a workshop attended by representatives of the water companies, including those that had not been involved with the day-to-day work of the project steering group. This broader consultation led us to identify areas in which further research was needed, and to modify aspects of our findings.

We do not identify sufficient grounds for recommending a move away from the use of relative efficiency analysis.

We identify ways to improve upon the relative efficiency analysis undertaken by Ofwat in 2004 in particular by developing time-series cross-sectional (panel data) models based on the underlying regulatory assumptions and by changing the treatment of special factors.

We set out the understanding that we have reached as to the different sources of evidence available and the process that might be involved in reconciling them.